Utility stocks are historically seen as dull but dependable. After all, they have assured demand despite limits on profitability due to heavy regulation. Investors also see these stocks as regular dividend payers—bond proxies, in effect—with investors confident of solid income streams, leading to low but highly reliable total shareholder returns with relatively little capital risk.
That may be true – but some, like this one, can be very profitable…
National Grid in the U.K. and U.S.
One such utility company that has often been called ‘reassuringly dull’ comes from across the pond, the U.K.’s National Grid plc (NGG). The company operates the U.K.’s electricity grid, connecting electricity generation from all sources (power stations, wind farms, solar, and hydro) to end users. National Grid also has energy investments in the northeastern U.S. as well as electricity interconnectors with Europe.
National Grid makes its money by acting as an intermediary between the generators of electricity and the local electricity distributing utility companies. It charges fees for maintaining the integrity of the network and the carrying of energy that is passed on to the consumer, so it is largely unaffected by the actual price of electricity charged by the generating firms.
In other words, NGG is a very defensive stock, because National Grid forms one of the key and largely indispensable parts of national (UK) and regional (US) infrastructure. So even if electricity consumption is reduced or generation methods are changed, power still needs to flow through a grid and the networks need always to be managed and balanced by the grid operator.
In the U.K., long-term rate structures have offered solid earnings and dividend growth at least in line with inflation. During the 2013-21 period, regulators allowed National Grid to earn a 7% real return on its transmission assets plus incentives; however, for the 2021 to 2026 timeframe, real return on equity of electricity and gas transmission networks have been cut to 4.3% and 4.6%, respectively.
National Grid earns about 45% of its profits from the U.S. After many years of high investments in the
U.S., the significant asset reshuffling announced in March 2021 was a turning point. The company agreed to buy PPL’s U.K. electricity distribution assets, Western Power Distribution, for a £14.2 billion ($17.45 billion) enterprise value, implying a significant 60% premium to the regulated asset value. National Grid funded part of the purchase by selling its Rhode Island networks to PPL for £3.7 billion ($4.55 billion), for an impressive enterprise value to regulated asset value (RAV) of 2, and by selling its U.K. gas transmission assets at a 45% premium to the RAV.
The rationale behind those transactions was to increase the weight of electricity networks over gas networks in light of the ongoing energy transition.
Latest Results and Dividend
National Grid’s latest results (reported in mid-November) were darn good, showing that first-half underlying operating profit jumped 51%, to £2.1 billion ($2.57 billion). This is thanks to higher revenues from its new distribution network assets in the U.K. Earning per share went up by 42% to 32.4p ($0.40) per share.
The firm did raise its fiscal 2023 underlying earnings per share growth guidance from a prior 5% to 7% to a new range of 6% to 8%, implying earnings per share for the year to total 69.6p ($0.85). The guidance upgrade is driven by the positive impact of high inflation on revenue and higher profit growth at National Grid Ventures, notably on higher auction prices across interconnectors.
The interim dividend was 4% higher at 17.84p ($0.22) per share. And it’s a good bond proxy—the dividend has not been cut since 1996. National Grid is also a Dividend Aristocrat, having raised its dividend every year since 1998 and delivering an impressive 6.3% average annual growth over the period. NGG has always had a high payment ratio (dividend as a percentage of earnings per share) of around 80%.
National Grid has an interesting dividend policy based on U.K. inflation. The target policy is to grow payments in line with CPIH (consumer prices index, including owner occupiers’ housing costs) inflation: a measure which extends the consumer prices index to include regular costs of living associated with home ownership and it is running at nearly a double-digit rate.
National Grid’s Outlook
The company’s stock de-rated a lot in 2022. Stronger recent updates and those interim results in November stopped the rot.
Despite the relatively high debt level, National Grid’s balance sheet appears sound because the company’s high leverage is supported by low revenue cyclicality and low operating leverage.
The NGG dividend looks safe enough. Thanks to the aforementioned high selling price of the U.K. gas transmission assets, National Grid should be able to continue to grow dividends in line with inflation. And with an attractive yield of 6.78%, NGG is a buy anywhere in the low-$60s.